Credit creation
Credit creation means that on the
basis of primary deposits
commercial banks make loans and
expand the money supply. It results
in multiple expansion of banks
demand deposits.
• It is an open secret that banks advance a major
portion of their deposits to the borrowers and
keep smaller part of them for the payment to the
customers on demand.
• Even then the customers of the banks have full
confidence that their deposits lying in the banks
are quit safe and can be withdrawn on demand.
• The banks exploit this trust of the customers and
expand loans several times than the amount of
demand deposits possessed by them.
• “This tendency on the part of the commercial
banks to make loans several times of the
excess cash reserves kept by the bank is called
creation of credit”.
Process of Credit creation
• The existence of a number of banks, A, B, C
etc., each with different sets of depositors.
• Every bank has to keep 20% of cash reserves,
according to law, and,
• Suppose, a person deposits Rs. 1,00 cash in
Bank A. As a result, the deposits of bank A
increase by Rs. 1,00 and cash also increases by
Rs. 1,00.
Balance sheet of bank A
Liabilities
Assets
Demand Deposits
100
Cash
Total
100
Total
100
100
• Under the double entry system, the amount of
• Rs. 1,00 is shown on both sides. The deposit of
Rs. 1,00 is a liability for the bank and it is also an
asset to the bank. Bank A has to keep only 20%
cash reserve, i.e., Rs. 20 against its new deposit
and it has a surplus of Rs. 80 which it can
profitably employ in the assets like loans.
Suppose bank A gives a loan to X, who uses the
amount to pay off his creditors. After the loan has
been made and the amount so withdrawn by B to
pay off his creditors, the balance sheet of bank A
will be as follows:
Balance sheet of bank A
Liabilities
Assets
Demand Deposits
100
Cash
Loan to B
20
80
Total
100
Total
100
• Suppose B purchase goods of the value of Rs.
80 from C and pay cash. C deposits the
amount with Bank B. The deposits of Bank AA
now increase by Rs. 80 and its cash also
increases by Rs. 80. After keeping a cash
reserve of Rs.16, Bank AA is free to lend the
balance of Rs. 64 to any one. Suppose bank AA
lends Rs. 64 to d, who uses the amount to pay
off his creditors.
Balance sheet of bank B
Liabilities
Assets
Demand Deposits
80
Cash
Loan to D
16
64
Total
80
Total
80
• Suppose D purchases goods of the value of Rs.
64 from S and pays the amount. S deposits
the amount of Rs. 64 in bank C. Bank C now
keeps 20% as reserve (Rs.12.80) and lends Rs.
51.20 to a merchant. And this goes on till nth
round then
•
•
•
•
The table shows the following points
(i) If the cash reserve ratio is 20%and
(ii) the initial deposit is Rs 100
The banks creates newly created money of Rs
400.
• The total demand deposits are Rs 500 (initial
deposit Rs 100 + credit creation Rs 400 = Rs
500).
• “The credit multiplier is the reciprocal of the
required reserve ratio”.
• Credit multiplier = 1/required reserve ratio
• If reserve ratio is 20%
• Then credit multiplier = 1/0.20 = 5
Limitation on Credit Creation
• The commercial banks do not have unlimited power of
credit creation. Their power tocreate credit is limited
by the following factors:
• 1. Amount of Cash
• 2. Cash Reserve Ratio
• 3. Banking Habits of the People
• 4. Nature of Business Conditions in the Economy
• 5. Leakages in Credit-Creation
• 6. Sound Securities
• 7. Liquidity Preference
• 8. Monetary Policy of the Central Bank
Limits to credit creation
• The capacity of the bank to create credit is
subject to certain limitations which are given
below.
• (i). Cash Drain
• (ii). Transfer of deposit to non bank financial
institution
• (iii). Willingness to borrow
• (iv). Different types of loan